FOREIGN CURRENCY TRANSACTIONS AND
HEDGING FOREIGN EXCHANGE RISK
Chapter 6
McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Foreign Exchange Markets
Foreign exchange rate
Purchase price of a foreign currency-- e.g., in December 2007 it
cost about 0.09 U.S. dollars (nine cents) to purchase one Mexican
peso.
From 1945 to 1973 countries had exchange rates fixed to the U.S.
dollar.
U.S. dollar was fixed to gold at $35 per ounce.
Balance-of-payments deficits in the U.S. during the 1960s doomed
this system, so, by March 1973 most currencies were allowed to
float in value.
Learning Objective 1
6-2
Foreign Exchange Markets
Exchange Rate Mechanisms
Independent float – currency value allowed to move freely with
little government intervention.
Pegged to another currency – currency value fixed (pegged) in
terms of a particular foreign currency (e.g., U.S. dollar), and
central bank intervenes to maintain the exchange rate.
European Monetary System (Euro) – twelve countries use a
single currency, which floats against other currencies such as the
U.S. dollar.
Learning Objective 1
6-3
Foreign Exchange Markets
Foreign Exchange Rates
Exchange rates, to the U.S. dollar, are published in many places
on the internet and in newspapers.
Exchange rates are reflected both as US$ equivalent (direct
quotes) and currency per US$ (indirect quotes).
For example, on February 15, 2008 the direct quote for a Euro
was $1.4595 and the indirect quote was $0.6852. As a point of
comparison, the direct quote when the Euro first appeared in 1998
was approximately $1.17 and the indirect quote was
approximately $0.85.
A direct quote is the reciprocal of an indirect quote and vice-versa.
Learning Objective 1
6-4
Foreign Exchange Markets
Spot rates and Forward rates
Spot rate – today’s price for purchasing or selling a foreign
currency.
Forward rate – today’s price for purchasing or selling a foreign
currency for some future date.
Premium -- when the forward rate is greater than the spot rate for
a particular day.
Discount -- when the forward rate is less than the spot rate for a
particular day.
Learning Objective 1
6-5
Foreign Exchange Markets
Option contracts
Foreign currency option – gives the right, but not the obligation, to
trade foreign currency for some period.
Put option – the option to sell the foreign currency.
Call option – the option to buy the foreign currency.
Strike price – the exchange rate at which currency will be
exchanged when option is exercised.
Learning Objective 1
6-6
Foreign Exchange Markets
Option contracts
Option premium – cost of purchasing the option, which is a
function of the option’s intrinsic value and time value.
Intrinsic value – is the gain that could be made by immediate
exercise of the option.
Time value – the value that derives from the fact that the currency
value could increase during the remainder of the option period.
Learning Objective 1
6-7
Exchange Rates and Foreign
Exchange Risk
Terminology
Export sale – a company sells to a foreign customer and later
receives payment in the customer’s currency.
Import purchase – a company purchases from a foreign supplier
and later pays in the supplier’s currency.
Foreign exchange risk – the chance that the exporter will receive
less or that the importer will pay more than anticipated as a result
of a change in the exchange rate.
Learning Objective 2
6-8
Accounting for Foreign
Currency Transactions
Accounting – sale transaction
One transaction perspective
Treats sale and collection as one transaction
Transaction is complete when foreign currency is received and
converted, and sale is measured at converted amount.
This approach is not allowed under IAS or U.S. GAAP.
Learning Objective 3
6-9
Accounting for Foreign Currency
Transactions
Two transaction perspective
Treats sale and collection as two transactions
Sale is one transaction and collection is a second transaction.
Sale is based on current exchange rate.
If exchange rate changes, collection is for different amount.
Difference is considered foreign exchange gain or loss.
Concepts are identical for purchase transaction.
Learning Objective 3
6-10
Accounting for Foreign
Currency Transactions
Transaction types, exposure type and gain or loss –
export sales
Export sale → asset exposure--if foreign currency appreciates →
foreign exchange gain.
Export sale → asset exposure--if foreign currency depreciates →
foreign exchange loss.
Learning Objective 3
6-11
Accounting for Foreign Currency
Transactions
Transaction types, exposure type and gain or loss –
import purchases
Import purchase → liability exposure -- if foreign currency
appreciates → foreign exchange loss.
Import purchase → liability exposure -- if foreign currency
depreciates → foreign exchange gain.
Learning Objective 3
6-12
Hedging Foreign Exchange Risk
Hedging -- protecting against losses from exchange rate
fluctuations. Companies often use foreign currency forward
contracts and foreign currency options.
Foreign currency forward contract – an agreement to buy or
sell foreign currency at a future date.
Foreign currency option – the right to buy or sell foreign
currency for a period of time.
Learning Objective 4
6-13
Cash Flow Hedges, Fair Value
Hedges, and Hedge Accounting
Hedge accounting – an offsetting gain or loss from the hedge is
recognized in net income during the same period as the gain or
loss from the hedged item.
Cash flow hedge – an accounting designation for hedges that
offset variability in cash flows of hedged items.
Fair value hedge – an accounting designation for hedges that
offset the variability in fair value of hedged assets and liabilities.
Learning Objective 5
6-14
Hedge Accounting
Hedge accounting examples
1. FC asset/forward contract/cash flow hedge
2. FC asset/forward contract/fair value hedge
3. FC asset/option/cash flow hedge
4. FC firm commitment/forward contract/fair value hedge
5. FC firm commitment/option/fair value hedge
6. Forecasted FC transaction/option/cash flow hedge
Learning Objective 6
6-15